Q.
What has changed now that Congress has averted the fiscal cliff?
A.
Now that the wrangling over the fiscal cliff is finally over, let's sort out exactly what happened and how it will affect doctors and other highly paid professionals. First of all, a big thank you to Mitch McConnell and Joe Biden, the only two of our national leaders who apparently still remember what the word compromise means- that no one gets everything they want. They managed to pull together an agreement that was passed by 172/188 House Democrats, 85/236 House Republicans, 89/97 Senators (mostly those who want to run for president in 2016 voted against it), and 1 Democratic President. That's pretty darn good in my opinion.
For the typical doctor, this bill was a big winner with a few downsides that will increase your taxes a little bit. Let's look at the various parts.
Doc Fix Was Passed
I hated to see the Medicare “Doc Fix” get tied up with the fiscal cliff bill, but since it was, that was the main reason I was happy to see the bill pass. No 27% pay cut for docs taking Medicare. That was the most important benefit in the bill to me.
Doctors Are No Longer “Rich”
President Obama over the last year or so has somehow managed to define “rich” as a taxable income over $200K/$250K (single/married). That was revised in this bill to $400K/$450K. While I don't have exact figures, I would guess that means only 10% of doctors are “rich” instead of perhaps 40%. On a national basis, the rich are no longer the “top 2%”, but rather the top 0.6%. All marginal tax brackets stay the same until you hit $400K/$450K. That should save a married doctor making $450K over $10K in taxes per year. Capital gains and dividend taxes were increased, but again only for those with a taxable income over $400K/$450K, excluding most doctors and similar professionals. To make things better, these tax brackets are now made permanent, which they never were under the “Bush” tax cuts.
AMT Finally Indexed To Inflation
The AMT exemption was never properly indexed to inflation and thus every year has hit more and more Americans. Doctors are especially hard hit, especially in high income tax states like New York and California. For 2013 the exemptions are set at $50,600/$78,750 (single/married) and are now indexed to inflation. I very much appreciate whoever slipped that one into the bill as it may keep me out of the AMT in the future, and it should lower the AMT for those who actually do get caught up in its net.
Social Security Funded Again
The employee portion of the Social Security tax was cut from 6.2% to 4.2% two years ago as an economic stimulus, then extended through 2012. Now I liked the extra $2K in my pocket as much as the next guy, but the truth is this was a dumb idea. We took a popular program that was already underfunded and instead of saving it by cutting benefits a little, we cut the existing funding for it. That was idiotic in my opinion. This was eliminated in the fiscal cliff deal, restoring funding for a good program. This will raise everyone's taxes ($1000 per year for a worker with a taxable income of $50K per year) and will raise taxes on most doctors by $2274 (double that if you're in a two-doc family) but the truth is this tax increase actually needed to happen.
No Marriage Penalty
The “married filing jointly” standard deduction, 10% bracket, and 15% bracket will continue to be double that of a single filer. That's good policy, especially for us married folk.
Estate Tax Exemption Remains High
The estate tax exemption will remain at $5 Million (actually $5.12 Million) per spouse and will be indexed to inflation going forward. That will keep most doctors from ever paying estate taxes, which is a good thing. For those few who do have to pay this tax, it was increased from 35% to 40%. Good thing doctors aren't rich any more.
Limited Deductions and Exemptions
Highly paid doctors will get hit with a bit of a stealth tax in that deductions and exemptions ($3800 for each dependent) will start getting limited at $250K/$300K. The phase-out occurs over $100-200K, so it shouldn't hit most doctors very hard at all, but many will pay at least a little more in taxes because of it. I'm not entirely clear how this will be calculated, but I believe it will do something like reduce your deductions by 1/3-2/3ds of 3% of your income over $250K/$300K up to 80% of your deductions. So if you're married with a taxable income of $400K, you'll lose maybe $2000 in deductions, for maybe $800 in additional taxes. The exemption phase-out for a taxable income of $400K will probably cause an additional tax of about $1500 for you and each of your dependents.
Other Tax Breaks
Other tax breaks were also preserved, but most of them are aimed at lower earners and won't affect highly paid professionals much. These include the child tax credit, earned income tax credit, American opportunity tax credit, teacher credit, tuition credit, and tax-free short sale debt forgiveness. State and local income taxes will continue to be deductible, and you will continue to be able to donate your IRA RMDs to charity without paying taxes on them. Obamacare taxes, of course, weren't affected by the bill. That increases employee Medicare taxes by 0.9% on taxable income over $250K and capital gains taxes by 3.8% on investment income for those with taxable income over $250K.
Like everyone else in America, there were parts of this bill I didn't like, but for doctors, there was far more right with this bill than wrong with it.
So for the obama tax, i.e. medicare 0.9% is that 250k on single or a couple? Same question for the investment income on the 3.8% medicare surcharge.
I love how we see the “Bush Tax Cuts” but the “Obama Tax”. At any rate, it’s $200K single and $250K married for the extra 3.8% investment income tax and for the 0.9% additional Medicare tax on regular income.
Note whatever taxes are mandated they are “congress” bills. The president might support them but he can only sign, veto, propose, or influence. Simple!! Now the bill has many good aspects especially since it does not have an end frame. Now on to the next opportunity to address our spending issues.
Notes on the above excellent commentary:
1. Employers will not, in many cases, be able to deduct correct Medicare tax on income of $250k+/couple because the tax will be levied on JOINT income. So, for example, if a physician earns $250k and his spouse earns $100k, the employers WILL NOT deduct the extra .9% because neither W2 rises above the threshold. However, on the joint 1040, the combined income of $350k will add another $900 to taxes due.
2. The portability rules for a deceased spouse’s unused estate tax exemption amount are now permanent. Physicians and their spouses need to be aware of this option and when to use it. The downside is that it will cost several thousand $$’s to file an estate tax return so it’s not an automatic decision.
3. Coverdell Education Account contributions of $2000/year/child were extended permanently (a pleasant surprise to me). When contributing this amount or less annually for a child’s education , we generally advise these over 529 accounts, but few people know about them.
4. You have until Feb 1, 2013 THIS YEAR ONLY to make a 2012 donation directly from your IRA to charity if you are at least 70-1/2. This is a fabulous opportunity for older working doctors (or retired doctors with high income) to get the full benefit of a donation.
5. The rules were relaxed on converting to a Roth 401k at work. If you have a 401k plan, ask your employer to add a Roth 401k option. It costs them nothing more and allows employees to take advantage of contributing to a Roth if they are so inclined.
It looks like the Coverdale accounts are limited to those with incomes 220k or less. Is there any way around this, like giving the money to your kids and having them contribute in their own names?
Yes, you can have your kids make the contribution.
I used to use ESAs, but now live in a state with a good 529 with a state tax deduction, so I’m using that. Vanguard won’t let you open them anymore, by the way.
Mrs. Turner:
I am curious why you normally advise Coverdell over 529? It seems to me that in most cases the the 529 is the better option, unless you are really concerned that those funds aren’t going to be used for education as intended.
Hi, Beau,
For several reasons. I should clarify that typically I am dealing with parents who are unaware of the Coverdell option and are investing $2000 or less annually.
1. Not all custodians handle 529s.
2. 529s are fairly rigid as to coordination between states and plans, while Coverdell funds can (generally) be invested as the owner pleases. As Dr. J says, the benefit varies from state to state.
3. Coverdell funds can be used for primary and secondary schools, including computers even if not required by the school.
4. 529 contributions are deductible, but only to in my state of Kentucky.
529s have benefits that Coverdells don’t, such as no income limits, which are easily bypassed by having the child gift the money, no age limits, and no contribution limits. The best of both worlds, imo, is to start with the Coverdell and as the parent can afford to contribute > $2000 per child annually, or another person wants to gift to the child’s education, add in a 529.
I won’t argue that, in theory, 529s are supposedly the better solution, but in practice, Coverdells are usually enough for young people to begin saving as they begin their families.
I had a question about the personal exemption phaseout and the limitation of itemized deductions ( Pease Provision)
Currently I and most likely most drs are hit by the AMT. Since under the AMT, the only deduction that can be taken is the home mortage interest deduction, the PEP should not have any consequence. Does the Pease provision lead to limitation of the home mortage interest deduction under the AMT ?
Not sure if you directed this at me, but here goes: it’s almost impossible to know how you will be affected because AMT is typically so dependent upon state income taxes which, of course, vary by where you live and other factors. Also, you should be able to deduct charitable contributions.
Here is a great calculator that I think you’ll find helpful: http://bit.ly/WNvW82 – hope this is helpful.
I believe the limitations of itemized deductions also apply under the AMT system for those deductions that still count under the AMT- like charity and mortgage interest.
I see a little different twist on the ESAs vs 529s. If I were going to use both, I’d use my state 529 up to the limits of deductability, them max out the ESA (for lower investment costs and better investment choices) before going back to the 529. Kind of like the old take the 401K up to the match, then max out a Roth IRA, then back to the 401K theory.
I’ve written about ESAs here:
https://www.whitecoatinvestor.com/you-dont-need-to-know-what-a-coverdell-is/
You’re right Barry. He seemed to be using that point with his speech after the bill when he referred to Congress paying for the bills they pass.
WCI- you may want to look deeper into
The AMT exemptions, as they phase out quickly over 150k.
I’m afraid I’m going to be looking at them very closely this year! If not for 2012, then surely for 2013.